What the US elections mean for taxes

Now that the US election is over, the focus in Washington has moved to the US’s budget deficit and its “fiscal cliff”. At press time, it’s uncertain whether the US will jump off of the cliff, or find a solution which involves restructuring taxes and spending. Lots of pundits are predicting no deal, while the financial markets seem to be counting on one.

In the meantime, whether it is a serious idea or not, ideas such as selling Alaska back to the Russians for its trillions of dollars worth of natural resources shows just how high the cliff is. Recent asset sales in Europe show that nations sometimes have to sell the family silver, too.

Washington experts seem to be looking toward a “doomsday scenario”, something in between a grand bargain and a cliff dive. It’s a bare-bones deal to get past the expiration of current tax and spending laws, with a plan for a second chance to fix tax policy and social benefit spending in 2013 which may include setting taxes on most investment income at 20 per cent. Higher tax rates will apply for upper income earners and on estate taxes after the new year.

Given the difficulty in predicting the short-term election outlook, we believe it is worthwhile to look forward to 2013, and consider whether President Obama’s re-election will impact the Cayman Islands. For the most part, the status quo prevailed in Washington – the White House and the Congress are in the same hands as before.

So after all the rhetoric and campaigning, will US policies regarding Cayman and offshore international finance, or other closely related policies, change meaningfully in the next few years? Put differently, could a new US Congress change their tax laws to try to reduce the need for offshore financial centres like Cayman?

The US budget is being slowly squeezed, between failing revenues and rising expectations. US citizens have become accustomed to cradle to grave benefits, but want the taxes of a free market economy with a safety net.

Politicians trying to satisfy both find themselves borrowing more and more money to make ends meet. Meanwhile, as the baby boom generation retires, more and more benefits are drawn out of the system while fewer and fewer workers pay taxes to support them. For US taxpayers, this means that eventually taxes are going to have to go up to meet expectations now, and to pay off the debt later.

For those of us in Cayman, we might expect that tighter rules on US taxes will drive capital offshore. This may be a benefit one the one hand, but on the other, tax policies for US investors, nonprofits and businesses will continue to tighten too, removing treasured tax breaks. For investors, more foreign source income could be taxed immediately.

The president’s budget may seek to end deferral on US companies’ foreign profits, making it less necessary to form and operate foreign subsidiaries and vehicles. For investment managers, commodity funds could lose their status as regulated investment companies. For pensions and charities, debt-financed unrelated business income from abroad could be taxed.

All of these changes could impact Cayman and other offshore financial centres by making foreign transactions less profitable and reducing the demand for our services.

One issue that became less likely with the Democrats winning the presidential election and expanding their majority in the US Senate is genuine tax reform. No doubt bills called “tax reform” will still be considered and might pass. But with a $1 trillion deficit, taxes aren’t being reformed, they are being raised. Republicans who thought they were one election victory away from moving to a territorial tax system similar to the rest of the world were disappointed.

President Obama has worked closely with leaders of multinational companies to build support for a budget deal. But these leaders are conceding loophole-closing revenue increases now, in the year-end deal, to close the deficit.

When tax reform comes around in 2013 in the second step of this process, for each potential benefit to corporations in tax reform, revenue will need to be raised to pay for it. But there will no longer be loopholes to close.

Business will be no better off thereafter, because their efforts to reform the US tax code to make US businesses more competitive in the world economy will falter as too expensive while President Obama and his Democratic allies in Congress raise more money to pay for social spending.

At Cayman Finance, we are working to educate US policymakers so they can make informed decisions about policies impacting us. Educating members of the US Congress about Cayman pays dividends because they can move past the myths and rhetoric and draft laws that are based on how the international finance really works.